Morningstar | Few Surprises in British American Tobacco's 4Q as Shares Remain Materially Undervalued
There were few surprises in British American Tobacco's preliminary results for 2018, given that the company had released a preclose trading update in December. BAT was in line with our forecast for EPS but missed on the top line. We are retaining our medium-term estimates and our GBP 45 fair value estimate for the ordinary shares. We think there is significant upside to BAT and the tobacco group more broadly, but we recognize that a number of exogenous risks must pass in order for sentiment to improve.Organic revenue, adjusted as if BAT had owned Reynolds American for the full year in 2017, grew 3.5%, driven by pricing of 7% and volume declines of 3.5%, in line with recent trends. A currency headwind of 6% was greater than our estimate, however, leading to a top-line miss. In addition, slightly weaker-than-expected volume in Asia may indicate that Glo is failing to offset the steep declines in combustibles in Japan. BAT's market share is encouraging, however, and Glo now represents 4.7% of the tobacco market there.
The strategic cigarette portfolio continues to perform well. Volume of these brands, which include the five brands formerly known as the global drive brands, plus the former Reynolds brands Newport, Camel, and Natural American Spirit, increased by 16%.
The consolidation of Reynolds has created heightened regulatory risk, especially since the Food and Drug Administration threatened to prohibit menthol in the United States, but Reynolds is a high-margin business with ample room to raise pricing over time. This was evident in the results, as Reynolds drove a 520-basis-point increase in the EBIT margin to 38%. Excluding the Reynolds impact, the margin grew by 40 basis points, a decent performance, given the costs of rolling out the next-generation product portfolio in new markets.
British American Tobacco is engaged in tobacco and nicotine products. This includes Co.'s Next Generation Products, comprising its vapour and tobacco heating products, and its oral tobacco and nicotine products such as moist snuff and snus. Co.'s U.S business (Reynolds American) brand portfolio which includes Newport, Camel and Pall Mall. These, and other brands including Doral, Misty and Capri, are manufactured in a variety of styles and marketed throughout the U.S. Co. has other international and local cigarette brands including Vogue, Viceroy, Kool, Peter Stuyvesant, Craven A, Benson & Hedges, John Player Gold Leaf, State Express 555 and Shuang Xi.
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